Transfer Taxes and the Tax Act: An Overview and Three Possible Responses

by Womble Bond Dickinson
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Individuals and businesses continue to evaluate the Tax Cuts and Jobs Act of 2017 (the “Tax Act” or “Act”) and, in particular, the specific effects on personal and business tax planning.  Our clients are asking us daily how they should respond to the changes in law.  In a prior newsletter, we summarized the Tax Act more generally and addressed the various aspects of personal, business, and estate tax planning affected by the provisions of the Act.  In this article, we will address more specifically the provisions of the Act affecting transfer taxes – estate, gift, and generation-skipping.  In addition, we will propose three specific responses to the question, “So what do I do (or not do) now with my estate plan?”

The Tax Act significantly alters the transfer tax exemption amounts of persons dying or making gratuitous transfers after December 31, 2017.  Effective January 1, 2018, the gift and estate tax exemption and the generation-skipping transfer (GST) tax exemption amounts have increased to an inflation-adjusted $10 million per individual or $20 million for married couples.  The final determination amounts have been calculated by the IRS to be $11.18 million and $22.36 million, respectively, for tax year 2018.  For some perspective, in 2017 each individual had an estate and gift tax exemption and a GST exemption of $5.49 million.  Thus, the Act effectively doubles the amount of assets that a US citizen or permanent resident may transfer free from federal transfer tax. 

But do not abandon your estate planning just yet – the federal estate tax is still in effect, and the elevated exemptions set out in the Act are prescribed to revert back to the lower, pre-Act amounts as of January 1, 2026. 

TRANSFER TAXES

Before addressing specific planning responses the Act, we should take a moment to provide a refresher course on federal transfer taxes.

Estate Tax

The federal estate tax is a 40% tax imposed on an individual’s assets which are transferred upon death.  The United States has had some version of a federal estate tax since 1916.  The tax applies to the gross estate – all of a decedent’s personally owned assets, no matter the character or value – passing upon death to most individual beneficiaries, trusts, and non-charitable entities.  The federal government allows an unlimited marital deduction for transfers to a surviving spouse, and an unlimited charitable deduction for transfer to qualifying charitable organizations. In addition, estates may deduct from the federal taxable gross estate debts, funeral expenses, legal and administrative fees, and estate taxes paid to states. The taxable estate equals the gross estate less these deductions.

Gift Tax

The federal gift tax was imposed by Congress in 1932 to thwart attempts to bypass imposition of the estate tax by making deathbed transfers.  The gift tax (currently a 40% tax) is imposed on an individual’s lawful transfer of assets to most individuals and trusts during the donor’s lifetime.  Certain transfers are exempt from gift tax: 

  • Gifts valued at a dollar amount of $15,000 or less to any one individual in a single calendar year (in tax year 2018)
  • Gifts to a spouse;
  • Payments of tuition or medical expenses on someone else’s behalf;
  • Charitable contributions; and
  • Certain gifts to political organizations.
  • Generation-Skipping Transfer Tax

The generation-skipping transfer (GST) tax (also 40%) applies to outright gifts and transfers in trust to or for the benefit of related persons more than one generation younger than the donor, such as grandchildren, or unrelated persons who are more than 37.5 years younger than the donor.  Congress enacted the GST tax in 1976 to prevent wealthy families from avoiding the estate tax in a generation by simply skipping over that (already wealthy) generation and distributing assets to or for the benefit of younger generations.  The effective GST tax rate has historically been, and remains under the new Act, extraordinarily harsh – it is applied at the highest marginal estate and gift bracket in effect at the time of the generation-skipping transfer.  In sum, the GST tax is basically a second round of tax at the highest applicable rates on transfers to generations once removed from the donor/decedent.

The Unified Credit

Each individual’s estate tax exemption amount and gift tax exemption amount is really a single unified credit – a large credit effectively exempts from transfer tax a set amount of assets which any US individual may either give away during his or her lifetime or transfer upon his or her death.  Thus, gifts which are not exempt from the gift tax will result in a reduction of available federal estate tax exemption.  Each individual’s generation-skipping transfer tax exemption amount is independent of the unified credit for gift and estate taxes.

RESPONDING TO THE TAX ACT

“So what do I do (or not do) now with my estate plan?”

Individuals with sophisticated estate plans often utilize formula clauses in their Wills and Revocable Trust Agreements.  Such formulas are based upon the estate and GST exemption amounts in effect at the time of death and basically, operate to control what goes where.  A formula may dictate what amount passes to a surviving spouse, versus to children, versus to trusts for grandchildren, versus to charity, or others.  

Following the passage of the Tax Act, it is imperative to review your planning documents (or your clients’ documents) to analyze the effect an existing formula clause will have in the current transfer tax environment.  Many wealthy individuals who believed their estate plans were sufficient for any tax environment are discovering that their testamentary intent is no longer being achieved in their old estate plan executed prior to the recent sea change in law. 

Consider these examples:

#1.  The will or revocable living trust agreement which you signed a decade ago first funds a family trust for children with the maximum amount of assets which can free of federal transfer tax upon your death, and then distributes the remainder of your gross estate to your surviving spouse. Your estate planning attorney knew that that the exemption amount in 2008 was $2 million.  Your attorney also knew that you had all of your exemption remaining, and your gross estate was most likely worth around $5 million, so you envisioned a pot trust for your surviving children holding the exemption amount and the remaining $3 million in excess of your exemption amount passing to your spouse.  But fast forward to this year, or next year, or some point before 2026, while the Tax Act remains in effect.  If you died in the current transfer tax environment with a gross estate of $5 million, your estate plan will result in all of your assets passing to that pot trust for children, and nothing distributed to your spouse or held for your spouse’s benefit.

#2.  You made lifetime gifts to children of all but $1 million of your remaining exemption amount at the time you last revised your estate plan.  Anticipating $1 million, or close to it, of remaining exemption at death, you made a specific bequest of your remaining exemption to the one child with whom you are in business and indebted in approximately that amount.  You direct that your remaining estate should pass outright to your spouse.  In light of the Tax Act, the single child to whom you left your exemption amount will receive roughly five times the amount you intended, and your spouse will receive millions less.

Many estate plans currently in effect cause the unintended results set forth in the above examples because of the significantly increased exemptions in the Tax Act.  To the extent your estate plan utilizes a formula funding clause to apportion assets among your beneficiaries based upon the estate tax rate in effect in the year of your death, you should review your estate plan with counsel to confirm your will and/or revocable trust still achieve your intended result.  In reviewing your testamentary documents, you may wish to consider any one or all three of the following:

Capped Credit Shelter/Family Share

One simple way to combat the problem of an over-funded credit shelter or family share based on a formula clause apportionment is to revise the plan to cap the funding formula.  You or your client may still choose to create a family trust, but may decide to limit the dollar amount apportioned thereto.  Many formula clauses contain language such as, “any and all assets which may pass from my estate without incurring federal estate tax” or similar language.  Revising those terms to add a pecuniary (specific dollar amount) or fractional share of the gross estate limitation is fairly straightforward, and can ensure the testator’s intent is achieved by not over funding one share to the detriment of another. 

Outright Transfers to Surviving Spouse

In the early and mid-2000’s when exemptions hovered closer to $1 million, many more clients utilized credit shelter trusts and qualified terminable interest property marital trusts to benefit loved ones and ultimately minimize estate taxes while preserving assets for future generations.  With smaller exemption amounts and thus smaller credit shelter shares, clients directed more assets to marital shares in order to take advantage of the unlimited marital deduction.  Because marital shares may have constituted a large percentage of a decedent’s total gross estate, many transfers to surviving spouses were made in trust to retain some dead hand control over those assets.  However, with the increased exemption amounts in the Tax Act and the ability for a husband and wife to transfer more than $22 million to future generations free of transfer tax, there may no longer be a need or desire for such large martial shares to avoid tax.  Clients may now consider simplifying plans to leave outright some of those assets which were formerly apportioned to a marital trust.  There are also likely income tax planning benefits to taxing more assets in the survivor’s estate and eventually receiving two step-ups in the basis of highly appreciated assets.

Disclaimers

In light of the flexibility afforded by increased exemptions, disclaimers may be even more attractive tools in the estate planning toolbox.   A disclaimer allows a beneficiary to review and adjust an estate plan after the testator’s death based on the wealth level of the beneficiary and the applicable tax environment.  A qualified disclaimer allows a beneficiary (the “disclaimant”) to bypass his or her own estate and effectively transfer assets to a default taker free of estate or gift tax.  It is important to consult counsel to confirm a disclaimer is properly structured and “qualified” under Revenue Code Section 2518.  To be qualified, a disclaimer must be made in writing within nine months of the event creating the disclaimed interest, and this disclaiming party may not use or enjoy any benefit from the disclaimed asset and may not direct to whom the assets pass as a result of the disclaimer.

Typical disclaimer plans enable a surviving spouse to fully benefit from the marital deduction but give him or her an ability to disclaim a portion or all of the assets in order for the disclaimed portion to pass to future generations.  The surviving spouse may adjust amounts passing along to future generations in order to reduce the spouse’s estate and reduce his or her own tax liability upon death, or, a child who either already has or anticipates having substantial wealth of his or her own may be given an ability to disclaim in favor of his or her children.  If the testamentary plan of the decedent directs that disclaimed assets default to the disclaiming child’s descendants, transfer taxes can be further minimized or even avoided.

CONCLUSION

The Tax Act and increased transfer tax exemptions contained therein may have a significant impact on your estate plan or your clients’ estate plans as currently drafted.  Particular attention should be given to formula funding clauses upon review to ensure the funding directed in the testamentary document achieves the testator’s or settlor’s intent.  Please let us know if we may be of service in reviewing your plan to confirm it still achieves your desired result.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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